THIRD QUARTER

INVESTMENT LETTER

 

Greetings,

 

The current market environment is striking a delicate balance between extended valuations in both equities and fixed income investments and modest economic growth globally. Investors appear cautious as cash balances have surpassed levels recorded during the Great Financial Crisis and the European Sovereign Debt Crisis, as reported in a monthly survey of fund managers conducted by Bank of America. Market consensus is pointing toward heightened volatility with an array of known uncertainties on the horizon. At Cornerstone Advisory, we have prepared for this environment and find resolve in our disciplined investment process and by maintaining a long term perspective.

Relief Rally

At the end of the last quarter, global markets were focused on the outcome of the U.K. referendum commonly referred to as “Brexit”. In the aftermath of the vote for the U.K. to leave the European Union, investors realized that the actual exit would take considerable time and the outcomes are highly uncertain. With the vote out of the way, equity prices were able to join fixed income prices at or near all-time highs. This market dynamic is often referred to as a “relief rally”, when higher prices are based on rosier investor expectations for the future rather than new fundamentally positive information.

At the end of October, the world is focused on the U.S. presidential election. Markets and betting forums have priced in a Clinton victory and a possible Democratic majority in the Senate. Should these expectations not be realized, another bout of volatility would likely take place over the short-term. It is important to recall that the United States has endured contentious political environments in the past and that our system of checks and balances has helped keep the country on course for economic growth more often than not. Today the economic landscape is underpinned by a strong labor market and income growth continues at a steady pace, as illustrated by the chart below.

 

This backdrop of a financially healthy U.S. consumer, as well as plenty of cash in investment portfolios, as mentioned above, suggests that the market is well positioned to endure the unexpected over time. As you can see in the chart below, fund manager cash positions were only higher shortly after the terrorist attacks in September of 2001. The steadily increasing cash position over the last few years also suggests caution as market valuations have extended.

 

Hope for the Best, Prepare for the Unexpected​

In the past, when fund managers have maintained large cash positions, as illustrated in the above chart, this has often been a contrary indicator for the stock market. A contrary indicator is something investors use in order to determine what not to do with an investment. Two likely explanations are as follows: When bearish herding occurs (negative sentiment about the stock market) amongst investors, they tend to ignore bullish information that does not support the consensus view. The other is that a large amount of cash on the sidelines is fuel for higher prices when investors realize that they have been overly pessimistic. A good example is the market reaction to Brexit earlier this year.

With this in mind it is also important to consider the clear reasons for being cautious in our outlook for the markets. Some of the uncertainties investors currently face are the sustainability of the European Union, the migrant crisis stemming from the Middle East, the large build of up debt in China, and an increasingly tense geopolitical environment. As investors it is important to realize that uncertainty is the natural state of the economy and therefore of markets. No one knows the outcome of any of these issues, which is exactly what drives the short-term volatility in the markets.

As always, our answer to the perennial state of uncertainty in markets and the economy is to maintain our disciplined process and identify as many investment opportunities as we prudently can for our clients. Our philosophy is that the long term performance of an investment portfolio can be bolstered by built-in protections and the sensible use of alternative investments. Furthermore, our ability to generate income in portfolios is an inherent strength in this environment of low interest rates and stretched valuations.

As always, if you have any questions, please contact us.

 

Regards,

 

The Cornerstone Team

© 2020 by Cornerstone Advisory, LLC

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